1. Field of the Invention
The present invention relates generally to the field of employee benefits, and more specifically to systems and methods for insuring against loss of retirement benefits. Yet more particularly, the invention relates to and is applied to retirement plans established under United States Tax Law, and under Title 26 of the United States Internal Revenue Code.
2. Description of the Related Art
Employee benefits are generally divided into welfare benefits (such as health care, disability and life insurance), qualified retirement benefits (may take the form of defined executive wealth accumulation programs).
Under a defined benefit plan, the plan document sets forth a formula for determining the amount of monthly retirement income to be paid to an employee after he/she reaches normal retirement (or some earlier retirement age). This formula is based on the employee's length of service or a combination of the employee's length of service and pay (either career pay or final average pay). The benefit is provided from a trust or annuity contract to which usually only the employer contributes. The amount of contributions necessary to provide the promised benefits for the covered work force is determined under minimum standards set out in federal law and the actual annual contribution amount is determined by the employer with the assistance of an actuary. Each employee's benefit is insured by a federal agency (called the “Pension Benefit Guaranty Corporation” or “PBGC”) and because of the minimum funding standards and the PBGC insurance, benefits to the employee are not solely dependent on the accumulations in the trust on behalf of the employee.
Defined contribution plans are retirement programs where the employee's final retirement benefit is determined solely by the value of an “account” that has been established within the plan for the benefit of the employee. Contributions to that account and investment gains or losses of the account during the employee's working career, are paid to the employee at normal retirement age (or some earlier age) as specified in the plan document. As is evident, the amount of the employee's retirement benefit is directly, and entirely, related to the accumulations in the employee's account. The PBGC does not insure defined contribution plans. Employers make contributions to defined contribution plans using some non-discriminatory formula, such as a percentage of each employee's compensation as defined by the plan. In addition, if the plan has a 401(k) feature (26 United States Code 401(k)), employers may make contributions to the plan based on an employee's election to defer a portion of his/her cash compensation into the plan (such contributions are called “employee deferrals.”) Plans with 401(k) features often allow for special employer contributions called “employer matching contributions” whereby the employer will make an additional contribution to the employee's account based on the amount of deferral the employee elects.
(References to code sections herein, such as 401(k), 401(m), 410(b), 415(c), etc. shall be understood to refer to sections of the United States Internal Revenue Code, United States Code, Title 26.)
All qualified retirement plans are required to adhere to strict tax laws and regulations set forth in the Employee Retirement Income Security Act of 1974 (ERISA), the Internal Revenue Code of 1986 as amended (IRC), various Revenue Rulings and Procedures, and Department of Labor regulations. The general standards of accuracy and completeness are unusually high. The IRS demands that plans comply both “in form” and “in operation” with the tax “qualification requirements.” Compliance “in form” means that the plan document language must comply with all applicable tax laws and regulations (as interpreted by the IRS). Compliance “in operation” means that the plan must be administered in strict adherence to its written provisions-even provisions that have been adopted solely for design reasons (and would not have needed to have been adopted to achieve “qualified” status). Both form defects and operational defects may result in the IRS “disqualifying” the plan or imposing a “correction program” on the plan. Either result would have enormous financial implications for the employer sponsoring the defective plan; therefore, employers are extremely careful to see that their plans comply with all regulations in regard to both features and practices.
Loss of Current Income
The Loss of income during a period of long-term disability has generally been addressed under an employer's welfare benefits through a long-term disability plan. The employer may choose to fund this plan through the use of a group long-term disability contract, individual insurance contracts, a self-insurance arrangement, or a combination of the above. This plan partially replaces the loss of regular earnings that would otherwise be paid during the employee's period of disability. Benefits under these disability programs typically stop at the individual's “ADEA cut-off age.” For a person who becomes disabled prior to the attainment of age 60, the ADEA cut-off age is usually age 65. For workers who become disabled after attaining age 60, the ADEA cut-off age is usually five years after the commencement of disability payments. This plan typically does not address the needs of disabled employees after retirement age. At retirement, a disabled employee's disability benefit will cease and income must be provided by a combination of Social Security benefits, qualified retirement plan benefits, and personal savings.
Loss of Retirement Benefits
Employees who have been covered by a defined benefit plan for most of their working career may have a portion of their retirement income needs met by their qualified retirement plan benefits, even if they suffer a long-term disability during their career. Defined benefit plans may provide that if a participant becomes disabled, service, and if applicable, pay, would be deemed to continue for purposes of determining the amount of the retirement benefit provided under the plan's formula. Some plans also commence paying benefits at the time of disability and continue paying benefits throughout retirement.
In contrast, under the typical defined contribution plan, if a participant becomes disabled and remains disabled beyond a period of “short-term disability” (during which the employee is usually compensated through the regular payroll), contributions to the employee's account under the plan will cease. Therefore, an active employee is at risk that if he/she should become disabled and contributions to the plan are not made, the value of his/her plan account at the commencement of retirement will be substantially less than it would be if he/she had not become disabled. The reduction in the value of the employee's account will produce a direct loss of retirement income to the employee. If the plan allows benefits to be paid at disability, the available benefits are based on the accumulations in the account to date, and immediate payment of benefits from the account increase the likelihood that the account will be depleted before retirement age, further exaggerating the problem. Since the introduction of 401(k) plans, many employers have entirely, or significantly, shifted the focus of their retirement benefits from defined benefit plans to defined contribution plans, often with a 401(k) feature, making this disability risk a reality for millions of employees.
The potential loss of retirement account values at age 65 (usually considered to be the “normal retirement age”) assuming disability occurs at certain ages that last for certain periods of time can be illustrated as follows:
Qualifying the Exposure
The diminution in inflation adjusted retirement income for every $1000 of annual employer pre-tax or employer matching contribution:
If disability occursAnd continues to age:at age:3545556525|$52,500$88,071$112,071 $128,357 35|$35,357$59,357$75,64245|$24,000$39,42855|$16,071The chart expresses the individual's loss in inflation adjusted incomeattributable to the assumed $1000 of annual contribution that would havebeen made had the disablement not occurred.Assumptions:1.4% real rate of return (that is, inflation adjusted)2.Plan withdrawals over 15 years starting at age 653.No salary scale. (That is, it was assumed that this individual'scompensation would not have increased during the period he/she wasdisabled.
In the foregoing chart, it was assumed that the individual's compensation would have remained the same during the period of disability. However, if it is assumed that the individual's compensation would have increased by a certain percentage (e.g. a commonly used “salary scale” such as 5% per year), the losses would be proportionately greater.
“Outside the Plan” Arrangements
Until the introduction of the invention, employers did not think it was possible to address this risk inside the 401(k) and other retirement plans by including disability insurance as a feature of the plan. Even though retirement plans may include “incidental health and welfare” benefits, there was no known way to structure the insurance without complicating the “non-discrimination” requirements that apply to all “benefits, rights or features” for plans subject to IRS Section 410(b) testing. Therefore, some employers have attempted to deal with this risk on the part of their employees by using various funding arrangements outside of the retirement plan. Each outside the plan arrangement presents significant problems.
Arrangement One—Increase the Group LTD Benefits
Some employers have increased the benefits payable under their group long-term disability (LTD) contract, or their long-term disability program, to cover the potential loss. For example, an employee who elects a 6% deferral and receives a 4% match to the 401(k) plan, might receive an additional 10% of pay benefit under the regular, or a supplemental, group LTD policy. There are three main problems with this approach.                Problem One—The insurance may not be “linked” to employee deferrals. Tax policy requires that no other benefits may be contingent upon an employee's deferral election under a 401(k) plan. If the employer links the amount of coverage under a group LTD policy directly or indirectly to the level of employee deferrals and/or employer matching contributions under a 401(k) plan, contributions to the plan will cease to be viewed as “elective deferral contributions” under the federal tax laws. And, since highly compensated employees and non-highly compensated employees elect deferrals at differing percentages of compensation, without the special tests applicable to deferrals, these contributions would not be able to pass the non-discrimination requirements. Alternatively, for the employer to set an arbitrary amount of insurance based on average contributions would result in some employees having their account funded more heavily if they become disabled, and other employees having their account under-funded in the event of disability.        Problem Two—The employee may be “over-insured.” Actuaries at most insurance companies are of the view that increasing the cash benefit payable during a disability will have an adverse impact on the rate at which some disabled individuals respond to rehabilitation. This is especially true if the benefit is provided on a tax-free basis, which is the design under many employers' group LTD programs. This risk of over-insurance would require a substantial, disproportionately large increase in the risk charge that must be imposed as part of the premium for the group LTD policy. Similarly, this over-insurance could create a substantial increase in benefit payments in a self-insured LTD program.        
Problem Three—The employee may not save the benefit for retirement. If the employee spends the additional benefit before his/her retirement years, the employer's objective will not have been achieved and the employee still has a significant risk of loss at retirement.
Arrangement Two—Continue Employer Contributions to the Plan
Some employers have attempted to deal with the employee's loss of contributions during a long-term disability by continuing to make contributions to the plan on behalf of the employee during the period of disability equal to the pre-disability level of contributions. There are three main problems with this approach.                Problem One—Difficulty with IRC Section 415(c). Certain tests are prescribed under IRC Section 415(c) that determine the maximum annual additions allowed to the plan in a plan year. This generally limits contributions to a defined contribution plan to 25% of the employee's taxable compensation paid by the employer. Since a disabled individual is receiving no compensation directly from the employer, the contribution limit becomes zero (25% multiplied by $0 compensation). A special provision of the tax laws permits the limit to be applied by assuming that a disabled employee's compensation continues during a period of disability at the same level that it was prior to the commencement of disability. However, the rule applies only if the participant is disabled under a very restrictive “any occupation” definition of disability. If an employer wishes to use a less restrictive “own occupation” definition of disability for the first two to five years following the commencement of disability (as most employers would desire), the special rule provides no relief for the tests prescribed under IRC Section 415.        Problem Two—Difficulty with Non-Discrimination Tests. Contributions that are made by the employer on behalf of disabled employees who are “highly compensated employees” (“HCE” as defined by tax laws) may have difficulty passing non-discrimination tests. Contributions that are made by employers on behalf of disabled employees under this approach may not be tested as matching contributions under 401(m) after the first 12 months. IRC Section 401(k) and 401(m) describe the parameters for allowing higher levels of deferrals and matching contributions to be made (on the average) by, or for, HCEs than are made (on the average) by, or for, non-HCEs. Since HCEs almost always make larger percentage of pay contributions than non-HCEs, if the employer continues the same level of contributions that it was making for the disabled individual prior to the disability and these tests no longer apply, the contributions would almost certainly be considered discriminatory.        Problem Three—The Benefit is Not Insured. An employer who decides to continue contributions during a long-term disability could also have a change of heart. The employer could choose to unilaterally cut back the continuing contribution—even with respect to persons who are already disabled. And the disabled individual is at risk that the employer will go bankrupt. Even if the employer has insured its risk, the benefits payable after bankruptcy would be retained by the estate of the bankrupt employer and would benefit all of the employer's general creditors (including the employees) on a pro-rata basis.Arrangement Three—Continue Employee Contributions from LTD Benefits        
Some employers permit a disabled employee to make contributions to the 401(k) plan out of the benefit he/she is receiving from the group LTD plan. There are three main problems with this approach.                Problem One—The LTD Benefit Must Be Taxable to the Employee. This approach avoids the IRC Section 415 and non-discrimination problems noted as Problem One and Two above only if the group LTD benefit is taxable to the employee. A number of employers have structured their group LTD benefit in such a way that the benefit under the group LTD policy is (or, at the election of the employee, can be) tax free. Employees would be giving up a significant tax advantage and a significant amount of disability income in order to be able to contribute a portion of the benefit to the 401(k) plan.        Problem Two—The 401(k) Plan and LTD Plan Must Cover Non-HCEs Equally. This approach is likely to avoid a discrimination problem with regard to availability only if most of the non-HCEs participating in the 401(k) plan are also participants in an LTD program that provides the same (or higher) percent of pay benefits than are provided to most of the HCEs. The minimum coverage standards of ERISA applicable to the 401(k) plan require coverage for many employees who work part-time (i.e. at least 1000 hours per year). These ERISA standards do not apply to the group LTD program and many employers do not provide LTD coverage to part-time employees. If a sufficient proportion of non-HCEs who are participants in the 401(k) plan are not participants in the LTD program, the availability of disability coverage under the 401(k) plan may not pass non-discrimination tests.        Problem Three—An HCEs Loss Cannot be Fully Covered. Because of the application of the 401(k) and 401(m) non-discrimination tests with regard to average contributions for HCEs and non-HCEs, an HCE may not be able to replace his/her entire pre-disability contribution. For example, consider an HCE who was contributing 6% of pay to the 401(k) plan, becomes disabled, and receives a 60% of pay LTD benefit. In order to continue his/her old contribution amount, he/she would need to contribute 10% of the LTD benefit. Such an increase in the deferral percentage for disabled HCEs would no doubt increase the average percentage for the HCE group and may result in failure of the 401(k) and/or (m) tests.        